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A Generalized Portfolio Approach to Limited Risk Arbitrage: Evidence from the MSCI Global Index Change

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Hau, Harald

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Abstract

We develop a framework to explore the asset pricing implications of simultaneous supply shocks in multiple assets in a setting with limits-to-arbitrage. The portfolio approach in Greenwood (2005) is generalized to allow for asymmetric information and therefore net positions of arbitrageurs against uninformed liquidity providers. We predict that announcement returns are not only positively proportional to the asset premium change of each stock (like in Greenwood), but also negatively proportional to the risk contribution of the arbitrage position captured by the product of the squared return covariance matrix and the vector of supply changes. The redefinition of the MSCI international equity index in 2001 and 2002 provides a powerful event study to test these predictions. We find strong evidence in favour of our generalized model of limited arbitrage. Moreover, asset pricing effects of weight changes across stocks are quantitatively similar for domestic and foreign stocks. MSCI stocks are therefore priced globally and not locally.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6094.

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Date of creation: Feb 2007
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Handle: RePEc:cpr:ceprdp:6094

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Related research
Keywords: index revisions; international equity arbitrage; portfolio theory;

Find related papers by JEL classification:
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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References listed on IDEAS
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  1. Dhillon, Upinder & Johnson, Herb, 1991. "Changes in the Standard and Poor's 500 List," Journal of Business, University of Chicago Press, vol. 64(1), pages 75-85, January. [Downloadable!] (restricted)
  2. Froot, Kenneth A. & O'Connell, Paul G. J. & Seasholes, Mark S., 2001. "The portfolio flows of international investors," Journal of Financial Economics, Elsevier, vol. 59(2), pages 151-193, February. [Downloadable!] (restricted)
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  3. Chan, Louis K C & Lakonishok, Josef, 1995. " The Behavior of Stock Prices around Institutional Trades," Journal of Finance, American Finance Association, vol. 50(4), pages 1147-74, September. [Downloadable!] (restricted)
  4. Greenwood, Robin, 2005. "Short- and long-term demand curves for stocks: theory and evidence on the dynamics of arbitrage," Journal of Financial Economics, Elsevier, vol. 75(3), pages 607-649, March. [Downloadable!] (restricted)
  5. William N. Goetzmann & Massimo Massa, 1999. "Index Funds and Stock Market Growth," NBER Working Papers 7033, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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